Builder Upgrades

What I still am unclear on is the pool and how (in my opinion) it's crazy to finance $40,000 into a mortgage when you *plan* on refinancing in a few years. By *plan* I mean you take out a mortgage that you know isn't what you want but you took it because the builder forced you into it with "incentives" or they just plain wouldn't build a house for you if you don't use their lender and the builders lender is looking out for the builder, not you. I guess you can't *know* that the pool won't add value . . . especially in a new area where there are no comps . . . but am I crazy here?

Another situation I don't get is with all the "upgrades" they try to get you to buy with a new house. Blinds, paint, water softener, ro water filter, counter tops, cabinet upgrades. I wonder if you would be better off just getting the cheapest options and then upgrading later when you can afford to pay cash. I can guess that's the case but people figure life is too short to live in a a despicable house that has a kitchen with laminate counter tops instead of granite!! (I have laminate and somehow my wife and I manage.)

And that leads me to the pricing on new homes and how the builder sets the price and somehow the lender will lend you money on a house that may or may not be worth what you end up paying (granite counter tops may add value to the house but probably not $10,000). The more I learn the more I realize how much I still have to learn.

Builder upgrades are an almost entirely different set of rules and calculations than after-market upgrades. There are reasons for this that mostly reduce to "The lender can do a lot of things if they really want to, but most lenders don't have a reason to want to." For all of this, keep in mind that my normal stomping grounds just don't have a whole lot of new developments any more, so I don't deal with developer issues a lot, and it's very possible for the rules to change while I'm not doing any developer deals. I'm working with one set of clients right now who might end up buying in a new development, but it's been over a year since my last set of clients who bought just one (although if there's any developers reading this, I do have one investment firm client who wants to buy out the last of any new development that isn't moving quick enough).

The normal after-market upgrade, if you want a normal mortgage loan for it, has to be justified in terms of the property's current numbers. In other words, if you want to take $50,000 cash out to put in a pool, you must already have $50,000 equity available to you. You have to qualify for that loan debt to income ratio and loan to value ratio exactly as if you were going to take that money and buy lottery tickets with it. In other words, without the value of the proposed pool or other improvement added to your property, but solely based upon the situation as it sits now.

With builder upgrades, however, there's a little more latitude built in - especially where the builder controls the lender outright. Sure, the property is really only worth maybe five thousand more with that fifty thousand dollar pool installed, but because the basic number equates to money in their pocket directly, as well as money that they're going to earn interest on, they have a motivation to be more forgiving than in the case of the lender who is not getting $50,000 placed into their left hand while they loan it out - at interest - with their right. In many cases, even if they don't control the lender directly because they're not that big yet, they've made an agreement to indemnify the lender for any losses they take as a result of lending that money. The builder is secure in the knowledge that they'll make a lot more from the increased number of upgrades than they'll lose from the small proportion of defaulters. However, this should explain to consumers why sometimes builder's preferred lenders can do things nobody else can - because they're getting paid to do it. Furthermore, because they can do something nobody else will, they can charge a premium, either in rate, points, or both, over general market rates. Because the consumer wants the home with these upgrades, and because this is the only way anyone will lend on it, there's money to be made! Usually, there's plenty of money to go around - the consumers are, in aggregate, paying for it. Surcharges and premiums on the secondary mortgage market can go anywhere from two and a half percent up to six percent, perhaps more. On a hundred $500,000 homes, four and a half percent is over two million dollars additional clear profit. Even if three of those homes default, losing roughly fifty thousand in each case, they've still cleared more than two million extra profit for having done this.

(This is not to say that many after-market contractors don't have their own finance department cranking out trust deed financing even if the equity may not be there to pay it right now. But this way they get the job, which means they make the money for that job, and most of these contractor loans carry rates well above regular current market, so they can make more on the job as well as on the loan. How remarkably analogous!)

As for whether it's smarter to upgrade with the builder or wait and pay cash, there's an argument for each side. On one hand, the argument for waiting is that you are a lot less likely to owe more than the property is worth if you need to sell. Furthermore, you're not paying interest on depreciating fixtures, a classic double whammy anyone who's even bought a car on credit can relate to. Because you're not asking for anything special or difficult in the way of financing, you can at least theoretically go anywhere for your financing. Builders in California cannot legally require you to use their lender, which is not to say it doesn't happen - sometimes very blatantly in violation of the law - but that's the theory, anyway, that you should be able to shop the market. Finally, the cost of most upgrades is rarely recovered in increased sales price when the current owner sells. Spending a dollar, and paying interest on it, to make back twenty cents in eventual increased sales price strikes me as shooting yourself in the foot. It is to be admitted, however, if it was worth a dollar to you to have the upgrade, the twenty cents is icing on the cake.

Against this, however, is the cold hard reality of labor costs. If you build granite counter-tops in the first place, the only increase in costs is the comparatively small increase for more expensive materials. If you wait until after it's done, you've got to tear all the old work you've already paid for out, then pay the labor costs to put the new counter-tops in, as well as new materials, the cost of haul away, etcetera - not to mention the restaurant meals you'll be eating while it gets done. At anywhere from $15 per hour up, plus benefits plus markup, that labor isn't cheap, and it's usually at least a couple of workers for several days.

Builders know all of this, and that it's very attractive to roll the upgrades into the cost like this. When they build a property "on spec" (meaning it hasn't sold before the framing is done at the very latest), they typically build in all of the upgrades they can, and if you went to them to take a completed property off their hands, but wanted something not upgraded, it's likely they will be unable to accommodate you (This is a negotiating opportunity on the rare occasions it happens!). They don't tend to build very many "on spec" around here, or anywhere else if they can avoid it without worse consequences, but that's what they do when they do it.

There's also one more argument in favor of builder upgrades: You won't get your extra money out of them, but in slow markets like right now, it's more likely the property will sell if you do need to sell it. There are always suckers out there who will zero in on the upgraded property because "it's soooo beautiful!" even though there are better bargains nearby. Real estate fixers and flippers worldwide make their fortunes on the backs of these people, but they're legal adults deciding this stuff is worth their hard-earned money. Who am I to say it isn't?

Builders set their prices on the same motto as Poul Anderson's Polesotechnic League: "All the traffic will bear!" Profit isn't evil, it's what motivates developers to build places for people to live. But there's nothing that says you have to cater to it by forking over excessive numbers of your hard earned dollars, either.

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